SLT: When we met at the Beneficial Owners Securities Lending and Repo Summit in Arizona you said everyone there hated you! What’s the real attitude of the securities lending community towards OneChicago?
David Downey: I speak a very different language than they do. They are in a very comfortable place dealing in a bilateral way with a loan - actually a disposition of an asset - whereby they get their forward agreements and they participate in splits. Their hands are being held by agent lenders and prime brokers, they get taken out to dinner and treated like royalty.
We came on the scene and explained there was another way to do this sort of lending without the ISLA agreements using transparent exchange trading and CCPs. Instead they can use EFPs (Exchange for Physical) with SSFs and that’s a difficult adjustment to make.
It has taken time to get [participants] over the initial hurdle. Most pension funds are not traders, they simply collect the money and then decide who will be working it. Then a trader comes in speaking trader language and talking about doing things differently.
So the brokers in that room recognise this product could move their customers into different arrangements where the customer would get bigger benefits.
SLT: But surely there’s room for both OTC and exchange-based securities lending in the market?
Downey: In every market there are organisations that move slowly and don’t have the necessary infrastructure.
However, look at the mid-size organisations that have the technology and would like to loan out their portfolios but are frustrated that they have to go through brokers in order to execute and participate in these processes.
The regulatory winds of Dodd-Frank are moving OTC transactions on to exchanges naturally - we are seeing this in fits and starts. I think it’s inevitable that OTC transactions will move to an exchange and be centrally cleared. Dodd Franks wants to promulgate rules that will encourage transparency.
So at some point participants will ask if they should spend the money on establishing a footprint, on hiring people, meeting regulatory requirements, building and documenting systems and interfaces, and then entice people to connect to that entity to create a facility for clearing OTC swaps including securities lending.
Or they could go to a clearing house that is accessible through the pipe they have already paid for and illuminate the port to an existing exchange - they can execute and clear these trades in a slightly different format but a lower startup expense.
At some point these firms will face that calculus.
SLT: How big an issue is transparency to the industry?
Downey: Securities lending rebates distort derivatives pricing as those pressures are priced in. There should be a more democratic nature to the market. All pricing on OneChicago gets disseminated in real time. We put out EFP pricing with attached interest components priced in relation to each other. This transparency will increase as more participants enter the market.
SLT: How much does OneChicago still use market makers?
Downey: The market makers on the CBOEdirect match engine make two sided markets in the majority of our products. Some of them also make two sided markets on our BETS execution platform for EFPs. for the smaller orders
On the instititutional size EFP side we don’t really use traditional market makers although many of the participants act like market makers - there is a different size in that market where firms are trading three or four thousand EFPs at a time and as more of those participants come in to play the market will get deeper and more liquid.
SLT: What products are attracting the most interest?
Downey: The launch of our OCX.NoDivRisk contracts has been a huge success. Dividends are not priced in but rather settlement prices are adjusted on ex-date which eliminates one of the risks of derivatives trading in longer dated contracts. With our new contract you have the stock price and the interest rate, it’s simple. You can hedge the interest rate risk easily with Eurodollars futures. But dividends are subject to change so with time the dividend risk becomes bigger - it means our volumes have been skewed to the short term.
With NoDivRisk contract, the dividend risk is taken out of the contract. On the morning of ex-date we adjust the price down by the then known distribution prior to the opening. This means the participants get the same benefit of a dividend without the risk it might change . We’ve seen a shift in our open interest to longer dated postions as people become more comfortable with longer timeframes.
We have been talking [to the authorities and our advisers] about EFPs using our OCX.NoDivRisk SSFs and feel comfortable that the trade meets the technical definition of Section 1058 of the tax code, which allows for non-recognition tax treatment on the initial sale of the stock and the eventual repurchase via expiry of the SSF.
SLT: Where else is the growth
coming from?
Downey: We are attracting new clients, even though they can only come on to the market to the extent that the clearing member allows them access. And because clearing members make money from securities lending they are often reluctant to give the access to their clients but this is beginning to change with Dodd-Frank changes looming
We have spent a lot of time educating people about OneChicago and everyone recognises that OTC transactions are coming to exchanges and/or SEFs. This is where the interest is coming from. We believe the business will grow, even from those businesses that have so far kept as at arms length want to benefit from securities finance tools.
We continue to talk to international players. It’s slightly confused with regard to withholding tax but they are coming to market. We’ve been more recently working with South American banks who are keen to use EFPs as a stock lending alternative. There is interest from European players, but I’m not sure they yet feel entirely comfortable from a compliance standpoint about doing these trades. Our view is that the benefits outweigh the risks so we should find some traction.
In anticipation of swaps and swap-like products moving to exchanges we have changed our pricing structure to reflect how participants are used to having swaps and the associated loans priced. So on May 1st of this year we began a two tiered fee structure of charging a per transaction fee of two tenths of a basis point in addition to a carry fee for every day the position is open of one one-hundredth of a basis point. Accordingly a position established and carried for a year will cost 3.85 basis points.
This highlights to all customers the real value in the equity financing transaction - the initial reaction for many in the market was that fees were going up which we could not argue with, but once we explained how much they will save by doing the financing here rather than elsewhere and that all the benefits will be embedded they were reassured. And as interest rates rise, the low rates we charge will become even better value. Our volumes have risen and our open interest has spread out to time as participants have realised that they only have to add a fraction of a penny to every trade, which doesn’t seem so bad from the point of view of the superior financing, protections and transparency that are offered.
SLT: Are pension funds getting
on board?
Downey: At one stage we thought pension funds would be the lowest hanging fruit as they had fiduciary duties and preferential tax status. But they’re not traders, they’re administrators, and they feel they have the relationships that can bring them value. They don’t have the trading operations and they don’t necessarily have the desire to increase their yields. They have to go to their boards to approve this type of trading - these boards aren’t experts in this field and are likely to refuse permission.
But we are seeing a lot of interest from mutual funds, endowments, hedge funds and so on who are interested in increasing alpha through better financing terms.
SLT: How much algo trading is done through the exchange?
Downey: We’re not seeing a lot of algo trading. We believe we will be able to attract them with the NoDivRisk product because at the moment they cannot accurately model the risk. In addition they look to arbitrage fleeting disparities and are not subject to onerous financing and carry costs. It might be something for the future.
Where we’re seeing the major volume growth is in block trading and EFPs which are financing tools like swaps and securities lending. We’re finding low transaction/high volume trades of large notional value. These customers are interested in getting the trade done correctly, rather than this very second. With EFP, there is no real need for speed.
SLT: Is the OneChicago model one that can be expanded internationally?
Downey: We are restricted as to the stocks we can list, and we can’t list foreign stocks - only ADRs. We are seeing securities futures in South Africa and India and it’s interesting that in those countries there is not a developed prime brokerage community to provide friction in those countries.
We believe the securities lending aspect is something portable to any exchange in any country. We have recently had a contingent from China who were very interested in what we were doing - I feel we really struck a chord. They may be able to use this activity as a form of securities lending surrogate.
We probably couldn’t jump our borders, but I can certainly see other countries setting up an exchange like ours.
SLT: What does the future hold for OneChicago?
Downey: I’ve never been more confident. The future at the moment is a bit muddied and confused as the final rules are still be discussed with the timeframes still uncertain. However it is clear that OTC trading, including securities lending transactions will be moving to regulated, centralised market centres with attached central counter party clearing organisations which we are prepared for.
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